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Adverse Selection in Credit Markets: Evidence from a Policy Experiment

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We test if riskier borrowers are willing to pay higher interest rates than safer borrowers are as predicted by Stiglitz and Weiss (1981). The data are from an Indian financial institution where interest rates are determined by competitive bidding. The government imposed an interest rate ceiling in 1993 and then relaxed the ceiling in 2002. Changes in default patters are analyzed before and after each of these policy changes. We find no evidence of adverse selection despite the use of collateral as a screening device. This study isolates adverse selection from moral hazard and controls for information on riskiness observed by the lender but not by the researcher.

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  • Ashok Rai & Stefan Klonner, 2007. "Adverse Selection in Credit Markets: Evidence from a Policy Experiment," Department of Economics Working Papers 2007-01, Department of Economics, Williams College.
    • Handle: RePEc:wil:wileco:2007-01
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    1. Dean Karlan & Jonathan Zinman, 2009. "Observing Unobservables: Identifying Information Asymmetries With a Consumer Credit Field Experiment," Econometrica, Econometric Society, vol. 77(6), pages 1993-2008, November.
    2. Demont, Timothée, 2016. "Microfinance spillovers: A model of competition in informal credit markets with an application to Indian villages," European Economic Review, Elsevier, vol. 89(C), pages 21-41.
    3. Karna Basu, 2011. "Hyperbolic Discounting and the Sustainability of Rotational Savings Arrangements," American Economic Journal: Microeconomics, American Economic Association, vol. 3(4), pages 143-171, November.
    4. Ahlin, Christian & Gulesci, Selim & Madestam, Andreas & Stryjan, Miri, 2020. "Loan contract structure and adverse selection: Survey evidence from Uganda," Journal of Economic Behavior & Organization, Elsevier, vol. 172(C), pages 180-195.
    5. Charles Grant & Mario Padula, 2006. "Informal Credit Markets, Judicial Costs and Consumer Credit: Evidence from Firm Level Data," CSEF Working Papers 155, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
    6. Christy Chung Hevener, 2006. "Alternative financial vehicles: rotating savings and credit associations (ROSCAs)," Community Affairs Discussion Paper 06-01, Federal Reserve Bank of Philadelphia.
    7. Ondřej Dvouletý, 2017. "Effects of Soft Loans and Credit Guarantees on Performance of Supported Firms: Evidence from the Czech Public Programme START," Sustainability, MDPI, vol. 9(12), pages 1-17, December.

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    More about this item

    Keywords

    Defaults; Risk; Auctions; Asymmetric Information;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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